Bond markets are benefitting as global equities plummet. Stock pundits make a compelling case for owning stocks versus bonds since double-digit percentage price corrections have been registered in most stock markets around the world since the start of the year. Stock dividend yields are now more competitive with income earned from bonds. This fact has led many strategists to a call for the reallocation of investment portfolio assets out of fixed income securities into stocks. We find fault with this reasoning for a number of reasons. The key points of our 2016 forecast from last month’s commentary are reprinted below to help explain our thinking.
Five Reasons to “Stay the Course” in 2016
Expectations for additional short-term interest rate hikes in 2016 are rapidly dissipating. At its December meeting, the Fed advised the financial markets to anticipate as many as four additional rate hikes this year. This expectation has been slashed: one or two rate hikes, at most, are now being forecast. We think the Fed will likely remain on hold for the balance of the year. The European Central Bank (ECB) indicated just last week that it is likely to lower its own short-term borrowing rate in March. Likewise, Japan is contemplating more aggressive monetary easing. Commodity prices, led by oil, are in a free fall. Global price inflation is non-existent and economic growth is once again slowing.
By extension, what is good for the U.S. Treasury market should also be good for the municipal bond market. Municipal bonds have already returned over 1% in January. Retail investor demand for tax-exempt securities continues to be very strong as evidenced by weekly mutual fund flow data. The seasonal uptick in supply issuance has not yet begun; however, the limited slate of new offerings has been well-supported as verified by steadily declining tax-exempt interest rates. High grade five-year municipal bond yields have dropped by as much as 25 basis points (.25%) this month; long-term bond yields are 10 basis points lower since the start of 2016.
Fallout from the latest course of financial events has led to further strengthening in the U.S. dollar. This occurrence has multiple ramifications. While U.S. Treasury yields continue to move lower, they are still attractive relative to other global rates. Foreign central banks and other international investors still want to own U.S. Treasuries. The weakening global economic picture, particularly in emerging market nations such as China, is exacerbating the flight-to-quality induced demand. Net Treasury debt issuance is not expected to rise, so supply will continue to be constrained. The strengthening USD translates into monetary gains for non-USD denominated investors holding U.S. Treasuries.
Commodities are priced and traded in USD. So, as the USD continues to strengthen vis-a-vis other global currencies, the cost of oil and other raw materials become that much more expensive for foreign buyers. While U.S. citizens might be enjoying the benefits of cheaper gasoline, other nations are feeling the opposite effect. The reason why the price of oil is making daily headlines is fundamental – the global economy is slowing. One needs to look no further than China, the world’s second largest economy and its major growth engine. The Shenzhen Composite Index has fallen into “bear market” territory this year, down by over 20% in January alone (-40% since its June 2015 peak).
Admittedly, we are probably a bit more pessimistic than most on the U.S. economy. We are not yet ready to predict a recession is imminent. However, since America is more intertwined into the global economy today, the possibility has increased. The economic slowdowns in China, Japan, Europe, Canada and South America cannot be ignored. Many sectors in the U.S. economy are under stress. The latest batch of fourth quarter earnings reports is not causing us to reconsider our pessimistic outlook. A weaker economy should stay the Fed’s hand and provide support to current interest rate levels.
How soft is the global economy? For a clue take a look at the nuts and bolts of global economic activity. The Baltic Dry Index measures how much it costs to ship “dry” commodities such as agricultural commodities and steel around the world. This bellwether of international trade crashed to its lowest level ever last week. The chart below shows the Index price performance since 1985 when the Index was configured in its current state.
This barometer of economic activity is often referred to as a “canary in a coal mine” for the condition of the world economy and future performance. A low price indicates trade is slowing, and the Index price has never been as low as it is currently. It is down over 70% since August. The Index cratered just prior to the 2008 global financial crisis; some economists say it predicted the crash. There are other instances when it forecasted global economic corrections. In 1999 the Index hit a 12-year low before the dot-com crash. Prior to the 2001 recession it experienced a very significant correction. Given the recent heightened volatility experienced in risk assets, we think further equity market volatility and global economic weakness are possible. Under this scenario fixed income investments, including municipal securities, should continue to produce positive results and outperform riskier asset classes such as stocks over the coming months.
But what if we are wrong and interest rates begin to move higher from here? Future simulation modeling, based on a variety of interest rate scenarios, suggests that an intermediate municipal bond model portfolio could produce positive performance over one-year and two-year time horizons. For the aforementioned reasons, we do not anticipate significant interest rate moves in either direction over the next twelve to twenty-four months.
Our analysis utilizing yield curve shifts of 0, -25, -50, +25 and +50 basis points is summarized in the following chart. Total return (coupon income + price change) is positive under all scenarios, including rising interest rates.
(Note that these are simulated gross and net returns and are not necessarily indicative of actual or future performance returns. Net simulated performance returns herein have been reduced by transaction costs, expenses and our management fees which will be borne by client accounts. Net performance includes the reinvestment of interest, and capital gains. Performance returns do not represent actual performance and there are inherent limitations in simulated results, particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser's decision-making if the adviser were actually managing clients' accounts.)
The first month of 2016 has provided plenty of excitement and new economic information for consideration. We expect the recent heightened degree of global market volatility will subside in the weeks ahead as investors get accustomed to the new global economic paradigm. Recent events make an even more compelling case for “Staying the Course” in their bond portfolios during the year ahead.
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